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The Fed statement noted that the downside
risks have diminished since the fall when it more than doubled
the size of the its asset purchases. This coupled with Bernanke's
comment that tapering is possible later this year with QE ending
purchases around the middle of next year.
These two components outweighed the downgrade in this year's
growth and inflation forecast, the first dovish dissent in
several years (Bullard wanting to the Fed to more adamant about
defending its inflation objectives in light of the recent low
readings. Although the dollar has been trending lower against the
major currencies since late May as the talk of tapering heated
up, helped by comments by Bernanke himself, it rallied strongly
against the major currencies in the aftermath of the Fed's
statement and extended those gains in response to Bernanke's
press conference.
Emerging market currencies, which have generally been under
pressure, extended their losses. US interest rates rose sharply
in response to the Fed and Bernanke. The benchmark 10-year yield
rose to new highs. This is likely to trigger a sharp rise
in European yields on Thursday and given the linkages with the
banks, may way disproportionately on financial shares in Europe.
The periphery in Europe, which is just seeing preliminary signs
of a cyclical recovery are particularly vulnerable.
The US equity market fell sharply and although this would usually
pose a challenge for Japanese shares, the weakness of the yen may
actually help support the Nikkei (and Topix).
The Fed's statement itself was largely the same as last time,
except for the acknowledgment that the downside risks had
diminished and that owing partly to transitory factors, inflation
was below the committee's long run objective. Longer term
inflation expectations remained anchored, in the Fed's opinion,
though we wonder how much of those expectations are a function of
the Fed's QE.
Barring a new deterioration in labor market conditions, we
suspect that the inflation story may become more salient in the
coming months and Bernanke seemed to confirm this in his
remarks.
Contrary to what some critics have argued, the statement and
forecasts suggest that the FOMC sees QE3 as being successful in
supporting the economy. The Fed's 2103 GDP forecast with a
midpoint of 2.5% is still about half a percentage point above the
market consensus. This warns that unless there is a substantial
change in the pace of growth in Q3, the Fed may revise down its
GDP forecast again in September.
The inflation forecast was also lowered to 1.2-1.3% (core
PCE) from 1.5-1.6%. Give base effect considerations, this too may
be lowered in September's update. So, while those who came
into today's meeting expecting the Fed would taper in the
Sept/Oct period have not reason to change their views,
anticipating the next changes in the Fed's forecasts suggests to
us that it is far from a done deal.
Bernanke made several points in the press conference that are
worth noting, though not unexpected. First tapering is not
tightening. Even if the Fed were to reduce the amount of assets
it is buying every month, it will be continuing to purchase
assets. Second, the thresholds of unemployment and
inflation are not triggers of policy. The Fed is not going on
automatic pilot and will continue to review the overall economy
and set policy accordingly.
Third, the Fed may lower its unemployment threshold from 6.5%,
indicating that the goal, which is likely to be what the Fed
considers non-inflationary level of unemployment is 5-6%. Fourth,
there is a consensus at the Fed not to sell the MBS securities it
has accumulated. There did not seem to be a reference to its
Treasury holdings. Fifth, Bernanke stressed the upcoming
data is key. This is not new, but worth emphasizing.
We have anticipated the tapering for late this year, but
recognize the risks that this may be pushed into next year. We
are concerned like Bullard about the low inflation. We also
recognize that the pace of job growth has slowed in the past
three months. We also see the advantages of allowing the next
Federal Reserve chairperson to taper and in so doing, bolster
their anti-inflation credentials.